1 / 17

Portfolio Theory (Jones chapter 7)

Portfolio Theory (Jones chapter 7). Investment Decisions. Involve uncertainty Focus on expected returns Estimates of future returns needed to consider and manage risk Goal is to reduce risk without affecting returns Accomplished by building a portfolio Diversification is key.

charla
Download Presentation

Portfolio Theory (Jones chapter 7)

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Portfolio Theory (Jones chapter 7)

  2. Investment Decisions • Involve uncertainty • Focus on expected returns • Estimates of future returns needed to consider and manage risk • Goal is to reduce risk without affecting returns • Accomplished by building a portfolio • Diversification is key

  3. Dealing With Uncertainty • Risk that an expected return will not be realized • Investors must think about return distributions, not just a single return • Probabilities weight outcomes • Should be assigned to each possible outcome to create a distribution • Can be discrete or continuous

  4. Calculating Expected Return • Expected value • The single most likely outcome from a particular probability distribution • The weighted average of all possible return outcomes • Referred to as an ex ante or expected return

  5. Example: Given the following probability distribution, calculate the expected return of security XYZ. • Security XYZ's Potential returnProbability 20% 0.3 30% 0.2 -40% 0.1 50% 0.1 10% 0.3 Solution: E(R) = Ripri= (20)(0.3) + (30)(0.2) + (- 40)(0.1) + (50)(0.1) + (10)(0.3) = 22 percent

  6. Calculating Risk • Variance and standard deviation used to quantify and measure risk • Measures the spread in the probability distribution • Variance of returns: σ² = (Ri - E(R))²pri • Standard deviation of returns: σ =(σ²)1/2 • Ex ante rather than ex post σ relevant

  7. Portfolio Expected Return • Weighted average of the individual security expected returns • Each portfolio asset has a weight, w, which represents the percent of the total portfolio value

  8. Portfolio Risk • Portfolio risk not simply the sum of individual security risks • Emphasis on the risk of the entire portfolio and not on risk of individual securities in the portfolio • Measured by the variance or standard deviation of the portfolio’s return • Portfolio risk is not a weighted average of the risk of the individual securities in the portfolio

  9. Risk Reduction in Portfolios • Random diversification • Diversifying without looking at relevant investment characteristics • Marginal risk reduction gets smaller and smaller as more securities are added • Correlation drives the diversification benefits • A large number of securities is not required for significant risk reduction • International diversification benefits

  10. Portfolio Risk and Diversification sp % 35 20 0 Portfolio risk Market Risk 10 20 30 40 ...... 100+ Number of securities in portfolio

  11. The benefits of diversification • Come from the correlation between asset returns • The smaller the correlation, the greater the risk reduction potential greater the benefit of diversification • If r = +1.0, no risk reduction is possible • Adding extra securities with lower corr/cov with the existing ones decreases the total risk of the portfolio

  12. Markowitz Diversification • Non-random diversification • Active measurement and management of portfolio risk • Investigate relationships between portfolio securities before making a decision to invest • Takes advantage of expected return and risk for individual securities and how security returns move together

  13. Measuring Portfolio Risk • Needed to calculate risk of a portfolio: • Weighted individual security risks • Calculated by a weighted variance using the proportion of funds in each security • For security i: (wi × i)2 • Weighted comovements between returns • Return covariances are weighted using the proportion of funds in each security • For securities i, j: 2wiwj × ij

  14. Portfolio Risk and Return • Expected Portfolio Return • Standard Deviation of Portfolio Returns

  15. Calculating Portfolio Risk • Encompasses three factors • Variance (risk) of each security • Covariance between each pair of securities • Portfolio weights for each security • Goal: select weights to determine the minimum variance combination for a given level of expected return

  16. Example: NOT on the EXAM 100% stocks 100% bonds

  17. Learning objectives Know the concept of uncertainty Know how to calculate expected return (probabilities) Know how to calculate portfolio expected return (weights) Concept of risk, portfolio risk Firm and market specific risks; correlation; diversification Know the concepts of correlation and diversification NOT on the EXAM p. 189 to 196: - covariance section p. 189-190 -calculations with standard deviations formula 7-12 section “the n-security case” End of chapter 7.1 to 7.5; 7.26; problems 7.1, 7-2

More Related